Do textual disclosures matter?
Evidence on corporate failure prediction, expanded audit report, internal control effectiveness, and capital market consequences

  • Mohamed G A A Elsayed

Student thesis: Doctoral ThesisDoctor of Philosophy (PhD)

Abstract

This thesis develops three essays investigating the feasibility of textual disclosures (which are also referred to as narrative-related disclosures) in corporate failure prediction and how such disclosures (particularly that of risk) relate to internal control effectiveness and ultimately the usefulness to the capital market participants as follows.
First, by creating a comprehensive corporate failure-related lexicon, this thesis explores the incremental explanatory power of narrative-related disclosures in predicting corporate failure. We find that corporate failure-related narrative disclosures significantly predict firms’ failure up to two years ahead of actual failure. Additionally, we find that a financially distressed firm would become more vulnerable when financial constraints befall, which in turn would precipitate corporate failure. Various robustness tests assure the credibility of the explanatory ability of corporate failure-related narrative disclosures to predict corporate failure. Collectively, our results show the feasibility of these narrative-related disclosures in improving the explanatory power of models that predict corporate failure.
Second, in 2013, the revised International Standard on Auditing (ISA) 700 (UK and Ireland) mandated the expanded audit report. The mandate seems not to be affecting investors’ reactions according to recent archival studies, leading regulators and standard-setters all over the world to raise a concern regarding the usefulness of the new reporting regulation and the information content of the expanded disclosure. Therefore, this thesis addresses this concern as follows. We first document that firms receiving an expanded audit report with a higher level of disclosure on risks of material misstatement (materiality) exhibit significantly higher (lower) idiosyncratic risk, beta and cost of equity. This finding suggests that expanded auditor’s disclosure meaningfully relates to the information risk that a firm presents to investors, implying that it is not generic. Thus, firms complying with the new reporting rule, which have relatively more reliable financial reporting, can benefit from lower information risk and cost of capital. Second, we find evidence that the new reporting regime relatively influences trading volume and volatility of market returns. Third, we find that information conveyed by the expanded auditor’s report is reflected in bid-ask spread, trading volume, volatility of market returns, and analyst forecast dispersion. Collectively, our analyses are consistent with the expanded auditor’s report regime and information content are associated with significant economic consequences for both the complying firms and capital market participants. This firm-specific and useful disclosure supports the FRC decision mandating the expanded audit report and encourages successors (IAASB and PCAOB).
Third, this thesis investigates the impact of internal control effectiveness on the level of textual risk disclosure (aggregate risk disclosure and its tone including good news, bad news, and net tone about risk). Our findings suggest that firms with an ineffective internal control system exhibit significantly lower levels of aggregate risk disclosure and its tone than firms with effective controls. Besides, our further analysis shows a significant change in textual risk disclosure behavior (higher levels of aggregate risk disclosure and its tone) provided by managers of firms with recurrent ineffective internal controls. Pursuant to agency theory, this behavior change is prompted to reduce the expected public uncertainty and agency problems that result from having recurrent ineffective internal controls. We also investigate the usefulness of the internal control effectiveness reporting and textual risk disclosure through observing their impacts on market liquidity and investor-perceived risk. Results suggest that firms reporting ineffective internal controls are likely to have more information asymmetry and investor-perceived risk than control firms. Furthermore, the evidence we find suggests that textual risk disclosure decreases information asymmetry, but does not affect investor-perceived risk. Finally, we illustrate that the information content of internal control effectiveness reporting and textual risk disclosure affect investors’ reaction around the 10-K filing, particularly for firms with a weak communication environment. Collectively, the results from our analysis fill an apparent gap in literature on the importance of internal control effectiveness, as well as the usefulness of the external auditor’s attestation on a firm’s internal controls and management textual risk disclosure.
Date of Award26 Nov 2020
Original languageEnglish
Awarding Institution
  • The University of Bristol
SupervisorTamer M F H Elshandidy (Supervisor), Kirak D Kim (Supervisor) & Mariano P Scapin (Supervisor)

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